New York City officials are defending their decision to let lead manager Smith Barney, Harris Upham & Co. reinvest the lion's share of proceeds from a recent water authority refunding.
Despite widespread criticism from syndicate members, city officials last week said they negotiated most of the reinvestment transaction with Smith Barney instead of doling out the responsibility through a competitive sale. The purpose of this move, they said, was to help the city obtain a yield match between its reinvestment portfolio and the bonds sold during the deal.
The reinvestment of the deal's proceeds is a lucrative job for Wall Street firms, and one that many banks in the syndicate had hoped would be sold competitively.
However, the city negotiated most of the transaction with Smith Barney, the refunding's lead manager, prompting many Wall Street firms to cry foul.
The city sold only $150 million of the deal's proceeds to the Street for reinvestment, while Smith Barney received the rest, city officials say.
Several Wall Street firms say the issue is whether it is fair for Smith Barney to act as a lead underwriter of the refunding while reinvesting the proceeds. One syndicate member said Smith Barney received most of the escrow award because of political connections with City Hall. Others said the city could have obtained a lower fee through a competitive bid.
Smith Barney declined to comment.
City officials denied the allegations and brushed aside all criticism of how the escrow's reinvestment was handled. Indeed, they say they negotiated a fee with Smith Barney that is well below what firms usually charge for proceed reinvestment.
Smith Barney had at first demanded 17/32 per bond spread as its premium to protect the investment firm from market risk, a city officials said. This spread is used to protect an investment bank from interest-rate swings-before it settles on reinvestment portfolio with the issuer.
But officials had demanded a much lower spread, reflecting a general obligation bond refunding completed by J.P. Morgan Securities Inc. in late 1991. Smith Barney and the city ultimately settled on a risk spread of 3/32, a city officials said.
City officials said they chose to negotiate most of the escrow investment to preserve the yield spread between the newly issued bonds and those the city sold during the advanced refunding.
In an advanced refunding, a municipal issuer sells new bonds and then purchases a portfolio of U.S. government obligations. Proceeds from the new bonds are given to an escrow trustee, and the cash flow on the deposited bonds are used to make debt service payments on the refunded bonds.
But an issuer, like the city in this case, also wants to closely match the yieled it pays on the newly sold bonds and its investment portfolio. The yieled preservation became a key issue in the New York City Municipal Water Finance Authority's deal because of negative arbitrage, which occurs when an issuer sells refunding bonds at higher yields than it can earn on reinvestment.
In the authority's case, negative arbitrage forced the city to invest in higher-yielding federal open market securities, rather than securities known as SLUGS, or state and local government series.
Slugs are a special kind of Treasury security issued to help state and local governments advanced refund outstanding debt. Maturities and yields are tailored to meet the municipalities' requirements and federal arbitrage restrictions.
But yields on slugs are lower than open market yields. And city officials feared that if they asked for competitive bids on the open market securities, the underwriter would in turn bid up the price of the open market bonds and increase the negative arbitrage.
